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Knightian uncertainty, Ambiguity, Winners’ curse, Market for lemons, Price formation, Auctions
This paper studies trade in a first-price sealed-bid auction where agents know only a range of possible payoffs. The setting is one in which a lemons problem arises, so that if agents have common risk preferences and common priors, then expected utility theory leads to a prediction of no trade. In contrast, we develop a model of rational non-probabilistic decision making, under which trade can occur because not bidding is a weakly dominated strategy. We use a laboratory experiment to test the predictions of both models, and also of models of expected utility with heterogeneous priors and risk preferences. We find strong support for the rational non-probabilistic model.